Federal budget 2016: Getting ready for an RBA v ScoMo showdown

If the market's economic tipsters are right, Malcolm Turnbull's double dissolution ambition has set up a showdown between the Reserve Bank and Treasurer Scott Morrison this Tuesday. The Law of Unintended consequences is always working.

The Reserve Bank normally has a week's clear air for its board meeting on the first Tuesday of May and the release of its quarterly statement on monetary on the following Friday. The statement usually provides a fine neutral view of the economy ahead of the very political version of the federal budget the next week. But not this year, thanks to Turnbull's Senate games bringing the budget forward a week to the RBA board meeting day.

The money market is betting the RBA will trim its cash rate by 25 points at 2.30 pm on Tuesday. That would effectively mean the RBA believes the Australian economy is getting worse and needs more help.

Then at 7.30 pm Scott Morrison has to deliver an election budget that will claim the government is doing a great job of handling the economy's transition and the future looks bright if we re-elect the coalition.

Advertisement

Federal Treasurer Scott Morrison and RBA Governor Glenn Stevens at a meeting at the Reserve Bank in September. Will there be a showdown next week?Credit:Peter Rae

And then, as the government is wrapping a week of selling the budget, the RBA's statement on monetary policy drops on Friday explaining what necessitated another interest rate cut only a couple of weeks after Governor Stevens warned monetary policy was rather close to its limits, reiterating an increasingly frequent RBA line that the government needs to step up.

It's a scenario for yet another unhappy day at the office for the federal treasurer. If it's a showdown between Morrison's credibility and that of the RBA…

Unknotting some rate cut knickers

But ScoMo might yet be lucky. The swing to tipping a rate cut on Tuesday is all thanks to the lower-than-expected inflation figures yesterday. Look more closely into the consumer price index breakdown and it's not so obvious that a rate cut is necessary.

And if you remember what Stevens said about the inflation target just four months ago, some rate cut knickers could be quickly unknotted.

The biggest factor in the headline CPI deflation was cheaper fuel – but cheaper fuel also works as an effective tax cut. It puts more money into drivers' pockets and thus contains a self-balancing element in the face of its inflation-lowering impact. Cutting interest rates to attempt to stimulate the economy because petrol is cheaper doesn't make much sense.

And then there's the breakdown between tradables and non-tradables inflation – effectively imported and domestic inflation. Tradables inflation was negative 1.4 per cent for the March quarter while non-tradables rose 0.4 per cent. Cutting interest rates might or might not increase demand at this stage, but it certainly won't have noticeable effect on the tradables story which is where the deflationary pressure is mainly coming from.

In fairness to the monetary hawks, the biggest surprise was how low the March quarter non-tradables printed. March is usually a higher-than-average for non-tradables thanks to the seasonal surge in education (school fees rise) and pharmaceuticals (the pharmaceuticals benefits subsidy recalibrates on January 1, people don't build up enough drug purchases to qualify for discounts straight away).

What the hawks mostly overlook though is one simple question for the RBA: Would trimming rates again really make much difference to demand at this stage, compared with the benefits of having some dry powder in case we really do run into trouble?

When negative interests elsewhere in the world have failed to spark inflation, it seems a little silly to think moving the cash rate from 2 to 1.75 per cent here would achieve much.

Stevens last week was quite blunt about the limits of monetary policy. On the heels of that, it's a big ask to expect the bank to cut when employment continues to rise, the national accounts for the past two quarters showed annualised GDP growth above what we might now think is trend and the NAB business conditions survey is unambiguously strong.

AFR: "Given the subdued inflation outlook, in terms of inflation targeting does it really matter much if inflation fell slightly below the two to three per cent range for a year or so?"

Mr Stevens: "I don't think temporary deviations matter. You know, if you thought about the, sort of, flipside situation where inflation was presently high but the economy was soft, then reasonably you could think, you know, it will probably come back down. Should we be further tightening from an already tight situation, or should we let it do its work? So the counterpart here is we've got a clearly expansionary setting. You know, you can make the argument to go even more expansionary, or you can make the argument, let it do its work."

"Inflation is a bit lower than we expected a year ago – partly that's oil. Partly it's that wages growth is a little bit lower than we thought – which, by the way, I think, is conserving jobs, and, you know, you have to think that's good. I don't think that's a problem unless it, sort of, locks into a permanently lower rate than people expect, and then expectations have to start shifting, and so on, but I don't think we see that at the moment. So, you know, I'm not especially worried by inflation being too low, as a problem. It is a bit on the low side, though, so that's part of the story of why rates have to be where they are."

AFR: "But what, is two to three better than one to two?"

MR Stevens: "In truth, you know, having thought about these things a lot when we introduced the two to three, I'm not aware of any persuasive evidence that two point something, or one point something, that you can tell the difference for economic performance, to be honest with you. I'm pretty sure that eight per cent for 20 years, like we had, is too high, and it's good that we broke that. When we were arguing about, you know, is it two, or two and a half, or one and a half, I don't think we have a strong factual basis on which to ground passionate arguments there."